Foreigners analyze how China's Bitcoin exchanges achieve "huge volume of transactions"

In the world of Bitcoin, not everything is as it seems.

Recently, a good friend of mine asked me about the situation of Bitcoin in China. He said that 90% of Bitcoin transactions are made by Chinese.

China’s role in the bitcoin industry is widely discussed and, of course, deeply misunderstood, and coverage of the subject is often accusatory.

I am planning to write a series of articles (this article is the first part) to discuss Bitcoin in China, aiming to correct this series of misunderstandings. In this series of articles, I will explain:

1. Why China’s Bitcoin Trading Volume is Misleading

2. China’s dominance in the mining industry has not translated into control;

3. When it comes to Bitcoin, don’t think in traditional terms.

These questions have become even more relevant recently, as bitcoin prices have plummeted after the People’s Bank of China (PBOC) interviewed three major Chinese bitcoin exchanges.

(Data from (cryptowat.ch))

Don’t take the apparent trading volume of Chinese exchanges as the real trading volume

When you first look at the volume of Bitcoin traded in China, you’ll notice that it’s massive. At the time of writing, the three largest Bitcoin exchanges in China (OKCoin, Huobi, and BTCC) trade a combined 1.863亿BTC per month, accounting for approximately 98.3% of global Bitcoin trading volume ^[1] .

(Data from (bitcoinity.org))

Most outsiders stop here and assume that this is the truth, and then conclude that "Bitcoin is a speculative toy for Chinese traders." But in fact, it is not what it seems on the surface. Let's start from the beginning.

Chinese Bitcoin Exchanges Implement Zero Transaction Fees

Due to the fierce competition in the industry, several major Bitcoin exchanges in China have provided fee-free trading services ^[2] . However, Bitcoin exchanges in other markets are different. Most exchanges abroad charge some transaction fees (for example, Bitfinex charges a fee of up to 0.2%).

So what is the relationship between zero transaction fees and Bitcoin trading volume? Because there are no fees, there is no friction in making any transaction. Comparing Chinese Bitcoin exchanges with US Bitcoin exchanges is like comparing apples and oranges. The embarrassing thing is that you can see this comparison in mainstream media such as Bloomberg, the Financial Times or the Economist ^[3] .

Incentivized trading volume

Most of the revenue of Bitcoin exchanges in the Chinese market comes from RMB withdrawal fees ^[4] . The RMB withdrawal fee rate is related to the trading volume of each trader (the more transactions, the lower the fee rate). This encourages traders to trade as much as possible so that they can get a lower withdrawal fee rate.

As Coinbase CEO Brian Armstrong recently commented, this creates an incentive for traders to trade as much as possible, even if they don’t generate any profit. Another way to think about it is that it encourages what we call “spam” trading (i.e. fake trading).

Wash Trading

A more malicious practice is wash trading. Simply put, a trader can set up two separate accounts and then use his trading software to trade back and forth at a high frequency.

If he has only one Bitcoin in his account, and he can make 1,000 transactions in a day, then this person alone can generate 1,000 BTC in trading volume... and this behavior will not affect the price of the currency, and there is almost no cost (zero transaction fees!) but his account balance is actually only 1 BTC. In other words, no "real" transactions have taken place.

In addition to private traders engaging in this practice, there are also reports that major Chinese exchanges themselves engage in inflated trading in order to increase trading volume on their platforms. ^[5]

More volume, more customers, and more funding

The main driver of trading volume (whether real or fake) is that traders want to trade on the platform with the best liquidity. And more liquidity means:

1. Smaller spreads allow buyers and sellers to trade closer to the market rate;

2. It is easier to add or close positions without causing significant fluctuations in the price of the currency;

Spam and wash trading will not help. They only increase trading volume, not liquidity. ^[6] However, increasing trading volume can differentiate a platform from other platforms, which means that increasing trading volume is the best way to attract more users.

In addition, exaggerating trading volume is also good for attracting investors, which can help exchanges complete the next round of financing. However, all signs show that exchanges are very profitable and in most cases, they can sustain themselves.

It’s not the volume that matters, it’s the liquidity

So is there any way to assess how much real Bitcoin trading activity there is in the Chinese market? Even without any spam or wash trading, the fee-free policy implemented by Chinese exchanges means that it is unambiguous to compare their trading volume with that of foreign exchanges.

One possible method is to compare the total amount of coins held by traders on Chinese exchanges with exchanges in other regions, but these data are confidential to the exchanges and will not be made public.

Observers can assess the depth of an exchange (i.e. the depth of the buy and sell orders), but for the reasons listed above, there is currently no reliable way to find out if these orders are real without testing.

The best way to assess the level of activity on an exchange is to test liquidity. To do this, we can set up a large order (say $100,000) and then watch the price move. Sadly, traders who do a lot of wash trading are usually not in a rush to break through these real large orders because they can use their competitive advantage (i.e., left hand to right hand, unless the market has price fluctuations).

Give me a number!

I have personally heard that the "real" total trading volume of Chinese exchanges accounts for about 40%-50% of the global trading market (no basis for this). Of course, this number is still huge, but it is still very different from the 90% claimed by laymen.

Chinese exchanges have more than just Chinese users

Another point worth noting is that some of the users who trade on Chinese exchanges are not actually Chinese. Many foreign traders (even many of them are “bankers”) also trade here ^[7] .

Furthermore, anecdotally, more Bitcoin is traded over-the-counter (OTC) in USD than on exchanges, which means that the volume on exchanges, whether in China or elsewhere, may be just the tip of the iceberg.

There is no doubt that trading activity in the Chinese market has a huge impact on the price of Bitcoin. If the demand for Bitcoin in the Chinese market dries up, the price of Bitcoin will suffer a major blow (see my comments on the incident in early 2017 when the Chinese central bank interviewed exchanges).

But overstating China’s trading volume would lead to the erroneous conclusion that Bitcoin’s value stems entirely from Chinese investors.

What really matters is China’s growing influence in the internet technology sector. It’s no accident that the most profitable Bitcoin companies are almost all in China. Startups and investors here recognize Bitcoin’s unique utility and historical importance. Bitcoin’s speculative potential is secondary.

(There are other things about Bitcoin besides price)

In the worst case scenario: if all Chinese exchanges are shut down, or Chinese traders get tired of Bitcoin and move to another hyped asset, Bitcoin still won’t disappear. Its value proposition is very strong. Until these highly unlikely scenarios come to pass, Bitcoin will continue to grow in China.

Chinese traders’ interest in Bitcoin will always be a key factor influencing the price of Bitcoin, but given China’s growing influence around the world, it is equally true for any asset, commodity or currency.

I’ll be updating the rest of this series on Medium discussing China’s role in the mining industry.

Original author's BTC address: 3QWRC6cxErxcgSvxxDQkG6GxmAU1ezVPr9

Notes:

Notes (↵ returns to text)

1. Monthly transaction volume is equivalent to 11 times the current total amount of Bitcoin, which is 16 million;↵

2. Whether it is ride-sharing, mobile payments or food delivery, in the Chinese market, there are always multiple companies competing through pricing. This leads to a vicious race to see who has the most money and survives the longest. The same is true for the Bitcoin industry. ↵

3. All of the above mainstream media reports cite the erroneous conclusion that China accounts for 90% of Bitcoin trading volume. With a few exceptions, mainstream media reporters have no desire to delve into this very new and challenging phenomenon. ↵

4. The second potential revenue stream is “float.” Users’ deposits, whether in fiat or digital currency, can earn interest. Most money service businesses (like PayPal) do this, and there’s no reason to think Bitcoin exchanges would be any different. ↵

5. There is precedent in China’s tech industry. The concept is similar to “brushing orders” and is widely used in e-commerce marketplaces such as Taobao to inflate sales of certain products. ↵

6. Normally, as in any other stock exchange, real volume and liquidity go hand in hand, if volume goes up then liquidity will also go up. ↵

7. Similarly, many exchanges in the United States and Europe also have many Chinese users (and "Zhuang"). ↵